Low-volatility investing explained

Low-volatility investing is an investment style that buys stocks or securities with low volatility and avoids those with high volatility. This investment style exploits the low-volatility anomaly. According to financial theory risk and return should be positively related, however in practice this is not true. Low-volatility investors aim to achieve market-like returns, but with lower risk. This investment style is also referred to as minimum volatility, minimum variance, managed volatility, smart beta, defensive and conservative investing.

History

The low-volatility anomaly was already discovered in the early 1970s, yet it only became a popular investment style after the 2008 global financial crises. The first tests of the Capital Asset Pricing Model (CAPM) showed that the risk-return relation was too flat.[1] [2] Two decades later, in 1992 the seminal study by Fama and French clearly showed that market beta (risk) and return were not related when controlling for firm size.[3] Fisher Black argued that firms or investors could apply leverage by selling bonds and buying more low-beta equity to profit from the flat risk-return relation.[4] In the 2000s more studies followed, and investors started to take notice.[5] [6] [7] In the same period, asset managers such as Acadian, Robeco and Unigestion started offering this new investment style to investors. A few years later index providers such as MSCI and S&P started to create low-volatility indices.

Performance

Low-volatility investing is gradually gaining acceptance due to consistent real-life performance over more than 15 years, encompassing both bull and bear markets. While many academic studies and indices are based on simulations going back 20-30 years, some research spans over 90 years, showing low-volatility stocks outperform high-volatility stocks in the long run (see image). Since low-volatility securities tend to lag during bull markets and tend to reduce losses in bear markets, a full business cycle is needed to assess performance. Over shorter time periods, such as one year, Jensen's alpha is a useful performance metric, adjusting returns for market beta risk. For instance, a low-volatility strategy with a beta of 0.7 in a 10% rising market would be expected to return 7%. If the actual return is 10%, Jensen's alpha is 3%.

Criticism

Any investment strategy can lose effectiveness over time if its popularity causes its advantage to be arbitraged away. This could apply to low-volatility investing, highlighted by the high valuations of low-volatility stocks in the late 2010s.[8] Still, David Blitz showed that hedge funds are at the other side of the low-volatility trade, despite their ability to use leverage. Others state that low-volatility is related to the well-known value investing style. For example, after the dotcom bubble, value stocks offered protection similar to low volatility stocks. Additionally, low-volatility stocks also tend to have more interest rate risk compared to other stocks.[9] 2020 was a challenging year for US low-volatility stocks as they significantly lagged behind the broader market by wide margins.[10] [11] Criticism and discussions are primarily found in various academic financial journals, but investors take notice and contribute to this debate.[12] [13]

See also

Further reading

A couple of books have been written about low-volatility investing:

Notes and References

  1. Black, F., Jensen, M. C., & Scholes, M. (1972). The capital asset pricing model: Some empirical tests. Studies in the theory of capital markets, 81(3), 79-121.
  2. Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81(3), 607-636.
  3. Fama, E. F., & French, K. R. (1992). The cross‐section of expected stock returns. The Journal of Finance, 47(2), 427-465.
  4. Black. Fischer. 1993-10-31. Beta and Return. The Journal of Portfolio Management. en. 20. 1. 8–18. 10.3905/jpm.1993.409462. 154597485 . 0095-4918.
  5. Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The cross‐section of volatility and expected returns. The Journal of Finance, 61(1), 259-299.
  6. Clarke, Roger, Harindra de Silva & Steven Thorley (2006), “Minimum-variance portfolios in the US equity market”, Journal of Portfolio Management, Fall 2006, Vol. 33, No. 1, pp.10–24.
  7. Blitz. David. van Vliet. Pim. 2007. The Volatility Effect: Lower Risk Without Lower Return. Journal of Portfolio Management. en. 34. 1. 102–113. 980865. 10.3905/jpm.2007.698039. 154015248 .
  8. Web site: How Can "Smart Beta" Go Horribly Wrong?. researchaffiliates.com. 2019-07-24.
  9. Web site: Comovement and Predictability Relationships Between Bonds and the Cross-Section of Stocks. Baker. Malcolm. Wurgler. Jeffrey. 2012.
  10. Web site: The Wall Street Journal . 18 September 2020. Some investors tried to win by losing less-they lost anyway.
  11. Web site: Wigglesworth. Robin. 2021-03-22. A fallen star of the investment world. 2021-09-15. www.ft.com. en-GB.
  12. Web site: Compendium of Low Volatility Articles. Hamtil. Lawrence. 2019-07-22. Fortune Financial Advisors. en-US. 2019-07-24.
  13. Web site: Deconstructing the Low Volatility/Low Beta Anomaly. Swedroe. Larry. 2018-07-12. Alpha Architect. en-US. 2019-07-24.